The Centre for European Reform is a think-tank devoted to improving the quality of the debate on the European Union. It is a forum for people with ideas from Britain and across the continent to discuss the many political, economic and social challenges facing Europe. It seeks to work with similar bodies in other European countries, North America and elsewhere in the world.

Wednesday, November 30, 2011

For the first time in the history of the EU, Germany is the unquestioned leader, and France is number two. Since the financial crisis struck in 2008, the economic inequality between France and Germany has grown. Although regular summits between Angela Merkel and Nicolas Sarkozy maintain the appearance of parity, France's higher levels of debt and public spending, its lower level of exports, its less well capitalised banks and its rising borrowing costs vis-à-vis Germany have forced it to accept German leadership on economic policy.

Last week I talked to officials in Paris about the eurozone crisis. The franker among them admit that on many of the key arguments – should the eurozone be run according to strict rules that minimise the scope for political discretion, should there be a treaty change, should the European Central Bank (ECB) intervene massively to support governments in trouble, and so on – German views have prevailed.

French officials fret about the sustainability of the euro. Their analysis is similar to that of the Anglo-Saxons: they worry that the German medicine being applied to the eurozone ignores the importance of demand and growth, and that few German policy-makers understand financial markets. But unlike the Anglo-Saxons, they think it better not to lecture the Germans in public on what they should do. The French think that the Germans will probably do what it takes to preserve the single currency, in the end. But several officials expressed the concern that, by the time the Germans decide to move, it may be too late to save the euro.

The French are reticent about the German plan to change the EU treaties. They assume that a new treaty will have to be preceded by a convention, as was the constitutional treaty. But when the convention – consisting of MEPs and national parliamentarians, as well as governments – meets, can the Germans ensure that it discusses only the euro, rather than every subject under the sun? Then there is the difficulty of ratifying a new treaty. The Irish, for example, would have to hold a referendum and in their current mood would probably vote no. But the French are going along with treaty change, because they hope that a new treaty with strict rules on government borrowing will make it easier for the Germans to change their current policies on the euro. In the short term that means accepting that the ECB should become a lender of last resort to eurozone governments.

In the forthcoming treaty negotiations, the French want to balance the German emphasis on budgetary discipline with some distinctively French thinking. Officials talk of treaty articles on economic growth and the co-ordination of macro-economic policy, tax rates and labour market rules. They also want to amend Article 136 of the Treaty on the Functioning of the European Union, which allows the eurozone countries to adopt new rules on budgetary discipline. The French want to broaden the scope of that article, beyond the Germanic preoccupation with budgets.

The French hope that the new treaty will pave the way for eurobonds, but know that collective eurozone borrowing only makes sense once budgetary policy has been centralised, which will take several years. In the meantime the French think that the eurozone needs a European Monetary Fund (EMF) to support countries in trouble. An EMF would, like the IMF, lend to countries that cannot borrow commercially, and set conditions. It would also lend preventively to countries that might face problems. It could be based on the European Stability Mechanism, the bail-out fund that is currently under construction.

Many parts of the French government would be happy to see an EMF become a rival source of expertise and power to the European Commission, though the Trésor has doubts about such duplication. France would like an EMF to take decisions by majority vote, so that it could move quickly and not worry about, say, a potential Slovak veto. But the Germans generally prefer unanimous decision-making on bail-outs.

The UK is in bad odour in Paris. Public lectures from David Cameron on what the eurozone should do have gone down badly (even though the French share much of his analysis). The French think the UK hypocritical: it says it cares about the single market but then wants special protection for the City in any new treaty – which as far as the French are concerned would be opting out of the single market. Would the French accept a special deal for the City in a new treaty? "Not if it erodes the concept of majority voting", said one official.

Like the Germans, the French say that if the UK asks for too many treaty opt-outs, they will go for a treaty that covers only the eurozone, or only countries in the euro plus those which plan to join it. The Germans are keen for the treaty to cover all 27 member-states, if possible, to make it easier for the Commission and European Court of Justice (ECJ) to discipline miscreants; the French, always sympathetic to the idea of a core Europe, are more relaxed about a treaty for fewer than 27. French officials disagree on whether it would be feasible for a eurozone treaty of 17 or 17+ to give the Commission and the ECJ a significant role. But they are all reluctant to see the ECJ involved in fining governments that breach eurozone rules.

At the moment, France and Germany are both hostile to the Commission but the French are even keener to minimise its role in managing the euro. They question its professional competence and worry about commissioners from non-euro countries voting on sanctions against, say, France. Paris wants such commissioners excluded from decisions on eurozone governance. The Elysée and the Matignon (the prime minister's office) are more negative about the Commission than the Quai d’Orsai or the Trésor – which think the Commission has a useful role to play in applying the recently adopted laws on budget discipline and eurozone imbalances.

But they are all critical of President José Manuel Barroso for his alleged "lack of vision". The French accuse the Commission of being invisible during the crisis and of not taking enough initiatives – though one official admitted that if it had been more active France would have complained. Among the criticisms I heard last week were that the Commission should have done more during the last decade to warn of the Irish and Spanish economies overheating; that it has pushed ahead with an EU-Mercosur trade accord, though this will harm French farmers and Mercosur has not offered reciprocity; and that although in July the EU asked the Commission to set up a task force to help Greece speed up reform, the task force did not start work till October.

François Hollande, the Socialist presidential candidate, has not yet said much of note on the eurozone crisis or the future of the EU. But he comes from the pragmatic, broadly pro-European wing of his party and his line on the EU is unlikely to be very different from that of Sarkozy. In fact Marine Le Pen, the leader of the Front National, brackets the Gaullists and Socialists together, saying that they are both - unlike her - for globalisation, the EU, the euro and immigration ( Marine Le Pen and the rise of populism). She is also an unremitting critic of the EU’s 'undemocratic' nature.

French policy-makers know that with national budgets likely to come under greater eurozone control, they will need to have an answer to those who claim that the EU is undemocratic. There is no love for the European Parliament in Paris. But officials talk of giving national parliaments a role in eurozone governance. They support Joschka Fischer's idea for a new committee of national parliamentarians to hold eurozone institutions to account.

The French government worries about Le Pen – who is currently polling between16 and 21 per cent. In past presidential elections the Front National has scored better than the polls predicted. If the euro crisis worsens, and requires France to adopt painful austerity measures, Le Pen's implacable hostility to the single currency could earn her extra votes. She could get through to the second round of the presidential election in May 2012, as her father did in 2002, though she could not win. The presidential election is unlikely to change the broad thrust of France's EU policy, but the euro crisis and the increasingly dominant role of Germany could push the French people in a eurosceptic direction.

Tuesday, November 29, 2011

Some of Germany’s European partners accuse Chancellor Angela Merkel of refusing, or failing, to lead properly in the euro crisis. Many Germans agree with that analysis and call for Merkel to guide the rescue efforts with a firmer hand and more vision. Just as many, however, think that Germany is actually leading well, and that this is not sufficiently acknowledged. As one opposition politician put it to me during a recent Berlin visit: “Germany is expected to lead, and if we do, we are criticised as arrogant – unless it’s in line with what others want.” I learnt that the way many Germans define leadership differs from the views that seem to prevail in other EU countries.

Recent remarks by Volker Kauder, head of the parliamentary faction of Merkel’s CDU (and the CSU), that Europe was now “speaking German” were crude – and treated as such by much of the German media. But the sentiment behind that statement is quite common. Many in the government say that leadership consists of spreading Germany’s ‘stability culture’ throughout Europe. They point to the fact that Greece is implementing reforms that were unthinkable until recently, that Italy is now run by a man who praises the strengths of the German model and that Nicolas Sarkozy is trying to get re-elected as president by promising to cut the French budget.

The Germans say they do not want to be the ones who impose austerity and reforms on their neighbours. They clearly do not enjoy being unpopular. And the experience of reunification has shown them how hard it is to salvage an ailing economy (in that case the eastern Länder) even if you can impose your own laws and practices. Merkel’s government therefore wants to construct new eurozone rules and institutions – but in a way that spreads and enforces a German vision of a ‘stability union’. (On how Germany should handle the euro crisis see 'Why stricter rules threaten the eurozone'.)

Accordingly, the German debate has shifted since the summer. The early debate had been focused on crisis management and blaming profligate South Europeans. Most Germans were spooked by the impression that market pressures were forcing their government into one U-turn after another. Opposition leader Frank-Walter Steinmeier liked to quip about ‘Merkel’s law’: the more fiercely Merkel rules something out, the more certain one can be that it will happen in the end.

In the last couple of months, the German debate has started addressing broader questions about the future of the euro and the EU. Political leaders are queuing up to make big European speeches. Now that the government talks about new treaties and institutions it looks more in charge. Politically, the strategy is working: almost two-thirds of Germans now approve of Merkel’s management of the euro crisis, up from 45 per cent in October.

However, the government’s vision for Europe is limited so far: a few ‘surgical’ amendments to the EU treaty to introduce automatic sanctions, take fiscal rule-breakers to the European Court of Justice and allow Brussels to intervene in the budgets of countries that ask for bail-outs. While Germany appears happy for the EU to curtail the sovereignty of countries that spend too much, it is reluctant to accept new constraints itself. During a recent Euro Group meeting, Finance Minister Wolfgang Schäuble obtained written assurances from his counterparts that the reprimands and sanctions of the new ‘imbalances procedure’ would apply only to countries with deficits, not those with surpluses. Spain in particular had called for more ‘symmetric adjustment’. Even economically literate Germans tend to react to such calls with simplistic statements such as “you cannot ask us to reduce our competitiveness and exports” or “we cannot increase our wages artificially to suit the eurozone because we also compete globally”.

A Germany in leadership mode would acknowledge that more German demand would help its troubled neighbours to export their way out of recession and that there are all manner of reforms (some of which the government is working on or contemplating) that can boost the German economy without ‘reducing competitiveness’. Here, Germany would do well to shed its Mittelstandsdenken (the conservative, inward-focused thinking deeply engrained in Germany’s small and mid-sized companies) and start behaving like a large country whose actions impact on the eurozone as a whole. (See also 'Why Germany is not a model for the eurozone'.)

One area, however, in which Germany will not lead is monetary policy. Observers from abroad often call on Merkel “to allow the European Central Bank to buy more Italian and Spanish bonds”. It is true that a majority of Germans is against the central bank buying government debt, mainly because they fear that ‘free money’ will allow South European countries to carry on borrowing, without implementing reforms and austerity.

However, most Germans do not think that they run monetary policy in Europe. They believe in central bank independence. There is no doubt that the ECB operates in a political environment that is substantially shaped by the German debate. But the idea that there could be a direct chain of command from the chancellery to the ECB or even the Bundesbank would be alien to most Germans.

In the eyes of most of the policy people I spoke to in Berlin, ECB bond-buying is dangerous, wrong, illegal … and inevitable. They know that the German political system cannot quickly come up with the sums that would be needed to finance Italy’s borrowing needs for any considerable length of time. First, Germany’s post-war political system was constructed specifically to prevent rash decision-making and strong leadership; a slow-moving, consensus-oriented political culture has developed as a result. Second, recent debates about bail-out laws have shown growing political opposition to committing more funds, in particular in Merkel’s own coalition. Any attempt to fill a ‘big bazooka’ bail-out vehicle with German taxpayers’ money could lead to political paralysis and early elections.

That only leaves the ECB. Berlin policy-makers shrug off the fact that Germany is routinely outvoted on the ECB board (votes are usually 17 against four). One person close to Chancellor Merkel said he wished the ECB was less hesitant in its bond-buying programme: “They should just announce that they stand ready to buy all Italian bonds, provided certain conditions are fulfilled.” Another told me it was “sad” that the Bundesbank and its boss, Jens Weidmann, were so dogmatic. But German leaders are very careful not to criticise central bankers openly and in public. (On what the ECB should do see 'The ECB must stand behind the euro'.)

No German government will instruct the ECB to “buy more bonds”. One government advisor says this would only prompt the ECB to defend its independence: “The more political calls there are for ECB intervention, the harder it gets for them to do what needs to be done.” Perhaps it is also time for German leaders to acknowledge that their routine statements about the wrongs of debt monetisation unsettle the markets, and just let the ECB get on with the job of stabilising the eurozone.

Monday, November 21, 2011

Europeans think it is all very unfair. They point out that, in aggregate, the eurozone is in no worse an economic position than the US: its public finances are in better shape than the US’s, and its overall level of private sector debt is actually lower. Yet for the past two years, financial markets have picked on the eurozone with increasing ferocity. In moments of bemused irritation, weary European policy-makers often complain about the baneful influence and biases of the Anglo-Saxon media, or the stubborn irrationality of financial markets. They would do better to reflect on why the eurozone faces an existential crisis while the US does not. The answer is that the two are very different monetary unions.

To start with, the eurozone is a much more decentralised monetary union than the US. The eurozone has no federal budget to speak of. Its closest proxy, the EU budget, is miniscule by comparison (at just 1 per cent of GDP) and cannot in any case go into deficit. Transfer payments are paid out of the EU budget, but these are not, strictly, welfare-related (the main recipients are special interest groups such as farmers). For all intents and purposes, the euro is a currency shared by fiscally independent countries. The upshot is that many things which happen at federal level in the US – deficit-financing, debt issuance, welfare payments, bank deposit protection, and so on – take place at national level in the eurozone.

Sitting atop the eurozone’s fiscally decentralised structure is a central bank which (for political, doctrinal and other reasons) is a more cautious institution than the US Federal Reserve, with a narrower understanding of its function. The European Central Bank (ECB) was deliberately designed as a successor to the German Bundesbank. The result is that it is more inflation-averse than the US Fed, and more reluctant to practice anything that might smack of ‘monetary financing’ (like acting as a lender of last resort to governments). In extremis, the ECB has implemented government bond purchase programmes. However, it has done so half-heartedly, and has always made a point of advertising its aversion to doing so.

So the US is a fully-fledged federation with a relatively flexible central bank, while the eurozone is a fiscally decentralised confederation with a conservative and limited purpose central bank. These differences are critical to understanding why the eurozone is the focus of market turmoil and the US is not. The crux is that the eurozone’s constituents interact very differently with each other than do those of the US: Germany does not stand in relation to Spain the way that Texas does to New Jersey, or eurozone countries in relation to the ECB the way that US states do to the Fed. The structure of the eurozone creates a whole host of problems that do not arise in a fully-fledged federation such as the US. Consider just three.

First, because they do not monopolise control of the currency in which they issue their debt, some countries are treated as if they have issued it in a foreign currency: this explains why Spain is paying 5 percentage points more than the UK to issue 10-year debt, even though its public finances are in no worse shape. Second, unlike the US, the eurozone lacks a joint fiscal backstop to the banking sector: this is why Ireland was plunged into a sovereign debt crisis, but the state of Delaware (where AIG is incorporated) was not. Third, banks and individual states interact differently: in the US, confidence in banks is not affected by the fiscal position of the state in which they are incorporated, but in the eurozone it is.

The eurozone’s structure, therefore, makes it a more fragile monetary union than the US. As a fiscally decentralised monetary union, it is vulnerable to the emergence of vicious ‘death spirals’ in some of its members. These spirals are driven by negative feed-back loops, in which worries about bank and sovereign solvency feed on and amplify each other. So far, eurozone policy-makers have done nothing to fix the structure that gives rise to these deadly spirals. Instead, they have preserved the structure, but made it more rigid. The eurozone remains a fiscally decentralised currency bloc, with a Germanic central bank. The only change is that member-states are now subject to tighter (and more pro-cyclical) fiscal rules.

The German government does not accept that the eurozone is institutionally flawed. It argues that the cause of the crisis is overwhelmingly behavioural, not institutional. The road to salvation is not to deepen integration by establishing a common bank deposit protection scheme or issuing debt jointly (which would increase moral hazard). It is to stop errant conduct. Ever since the crisis broke out, the German mantra has been fiscal consolidation and structural reforms. The underlying assumption is that the eurozone will be fine if it can turn itself economically into a larger version of Germany: countries that consolidate their public finances and reform their economies will end up with German borrowing costs.

It is not hard to see why many Germans find this account so compelling. It speaks to the very real sacrifices that many have made in recent years (for the past decade, German workers’ wages have barely increased in real terms). It suggests that the eurozone need not become the ‘transfer union’ of German nightmares. And it is supported by undeniable evidence of turpitude elsewhere: there is no doubt that Greece mismanaged its public finances, or that countries in southern Europe (and elsewhere) did too little to reform their economies. But what the German narrative does not explain is why the eurozone has proved so much less stable than the US, even though some of its underlying problems are no worse.

The extreme polarisation of government bond yields inside the eurozone does not represent a vote of confidence in the German economy, but a total loss of confidence in the very future of the eurozone. What the financial markets have cottoned on to is the fact that the euro is a post-national currency shared by countries that remain more attached to their fiscal sovereignty than they care to admit. The problem, in other words, is not financial, but political. The eurozone does not need financial assistance from China (or anyone else). It needs its leaders to do something that few have a democratic mandate to do – that is, pool their fiscal resources. Financial markets, for their part, are simply drawing their own conclusions.

Philip Whyte is a senior research fellow at the Centre for European Reform.

Tuesday, November 01, 2011

Since the financial crisis began in 2008, EU countries have cut military spending by an amount equivalent to the entire annual defence budget of Germany, Europe's third largest. While the prospects for an economic upturn are dim, the need for credible militaries remains strong – all the more so because the US is signalling that it may not lead future operations in and around Europe. The EU has been urging its member-states to seek defence savings in collaboration. EU officials frequently stress that member-states have no option other than to 'pool and share' their militaries: to make a more common use of training and support facilities, to buy equipment together and to form joint units. Unless such savings measures are taken, the defence cuts will undermine Europe’s ability to respond to future crises on its periphery and beyond.

But what makes obvious sense to experts and officials looks very different to national defence ministers. In most European countries the public care little about defence and will not hold governments responsible for how defence budgets are spent.

From a government point of view, collaboration carries real political costs because opposition politicians and journalists will accuse the ministers of undermining national sovereignty by creating interdependencies with other militaries. Collaboration often takes years to put in place and yields rewards only long after its architects have left office. Initially, it may also cost more than it saves. And defence ministers have little guarantee that any savings which their decisions generate will flow back to the defence budget; often the treasuries take the spoils. So unsurprisingly, many European defence ministers choose the politically safer route of inaction.

The EU is right to want the member-states' militaries to work together. But its approach needs to start with the recognition that defence ministers will need new incentives to do so.

Some help is already on offer. The EU, via its European Defence Agency (EDA), has recently formed a senior expert group, composed of mostly retired high-level officers. They are travelling around Europe sounding out governments on their plans to pool and share and urging them to try harder. The experts should also make it a priority to identify the obstacles to collaboration in each country, and to collect lessons on how countries have been able to overcome national reservations.

The EDA’s planned study on the financial benefits of military collaboration will also be helpful: little hard data exists on potential savings, and a credible risks and benefits analysis would give proponents of pooling and sharing an additional argument against the sceptics. So would another planned EDA study on the depth of past and probable future cuts to European defence budgets. Similar reports, such as the one recently produced by the German Stiftung Wissenschaft und Politik, make for a sobering read and implicitly help build the case for closer collaboration.

More could be done: the EU institutions could help governments identify strategies that generate maximum savings while entailing minimal losses of national sovereignty. The Netherlands and Belgium point the way: they have completely pooled the maintenance and training of crews for their navies' vessels, but they have kept the actual fleets under separate national ownership. They thus reap the financial benefits of collaboration (because they no longer duplicate schools and repair docks) while preserving the right to deploy the vessels where each government sees fit. The report by EDA's senior experts should highlight such successful collaborative strategies and the EDA should make certain that these are widely distributed. Not all defence ministers will read the experts' conclusions so perhaps follow-up visits by the experts - this time to spread lessons learned on pooling and sharing -- may be in order. And because ministers come and go, the EDA should also make sure its experts speak to the armaments and defence policy directors.

As its next step, the EDA should help defence ministers obtain assurances that savings generated through collaboration will be reinvested in defence. While each EU country has a somewhat different way to fund defence, some ideas might find universal application. For example, the French pay for defence through a five-year, legally binding budget allocation. This could be tweaked to allow the defence ministries to keep any savings generated during the life of the budget framework. In Slovakia, the government has pledged to take past reforms into account when cutting the budgets of line ministries in the future. Departments that found savings will have their budgets cut less dramatically than those that have not reformed. Other governments will want to pursue other solutions - the key point here is that defence ministers must feel that they will be able to reap the benefits of pooling and sharing; that they will see a reward for taking political risks.

Lastly, the EDA should explore whether governments can be offered direct financial incentives to pool and share. NATO has long recognised that if its member-states are to connect their militaries, they need help covering the costs directly related to building the physical links. So the alliance created a centralised pool of money, into which all allies pay and which reimburses governments for 'networking' costs, such as the upgrades that were needed at Central European airfields and ports so that they could fuel and communicate with West European aircraft and ships.

Pooling and sharing also essentially requires states to build a network, which entails initial outlays even though it saves money later on. For example, if two countries merge their military colleges, they will need to shut down some facilities and pay some of the personnel a severance fee. The prospect of such initial outlays may well discourage co-operation. So the EDA should sound out its members about the possibility of creating a 'pooling and sharing fund' to reimburse the costs that result when governments choose to enter into military collaboration. Alternatively, because most EU countries are also members of NATO, they could agree to use NATO's fund to encourage pooling and sharing. However, the fund would first have to be expanded (in recent years it has run low on money) and its mandate broadened from funding infrastructure upgrades to include other costs such as severance payments or clean-up of disused military facilities.

There may well be additional ways to entice the governments to pool and share. The EU institutions should make it their priority to identify such incentives and apply them as much as possible. Pooling and sharing may make eminent economic and military sense, but they are fraught with sensitivities and political dangers. The national governments will need all the help and encouragement they can get.